Author: John McHale

I give my take on last week’s deal today in the Sunday Business Post.   Cliff Taylor has kindly allowed an unedited version to be posted here.  

After the drama of Wednesday’s late-night liquidation of IBRC, attention turned on Thursday to attempts to make sense of the deal on the promissory notes.  To assess the merits of the deal, economists were looking for answers to four big questions: How would the deal affect the burden of the IBRC debt as measured by the present value of the state’s obligations?   How would it affect the funding pressures on the state over the next decade?   What would be the impact on the General Government deficit and thus on need for further austerity measures?   And would the deal ease the precarious position of having to get ECB approval of Exceptional Liquidity Assistance every two weeks?  

We must follow the money the money to answer these questions.

Too good to miss . . .

Re Box 6, By Gavin Kostick

[Scene: A spacious drawing room in Frankfurt. A patient is strapped to a table. M Drachet in attendance, plus admirers]

M Drachet: Our diagnosis for this fellow is an excess of partying, too much of the punch-bowl, a surfeit of humours, grass corpulence and a palpable debt overhang. Our remedy? Leeches!

[Enter Mr deKrugman, a plain talking Yankee]

Mr deKrugman: Hold your hand, sir! The patient is week. Leeches will only distress his condition further.

M Drachet: Oh that annoying fellow. Even your fellow Americans agree that leeches are the cure.

Mr deKrugman: Not any more they don’t. They’ve changed their minds.

M Drachet: Really? Never mind – bring on the leeches.

Mr deKrugman: Rather than leeches, this fellow needs an infusion of fresh blood to recover.

M Drachet: Are you volunteering?

Mr deKrugman: You, sir, can create all the blood you wish and you know it.

M Drachet: Balderdash.

[A fop whispers in M Drachet’s ear]

M Drachet: Well that’s news. But you forget, our medical charter expressly forbids it. And you miss the nicer point, if we were to do so, this fellow would learn nothing from his foolishness and return to his profligate ways.

Mr deKrugman: Are you trying to cure the fellow, or teach him a lesson?

M Drachet: A soupcon of A and a morsel of B. Now, the leeches.

[The leeches are applied, and the patient becomes noticeably paler]

Mr deKrugman: Told you.

M Drachet: You really are the most arrogant fellow.

Mr deKrugman: Says the man with the leeches.

M Drachet: But this is part of the cure! You see he is being purged, in in being purged he will ultimately return stronger.

Mr deKrugman: Or dead like that poor Greek fellow.

M Drachet: And anyway, you quite misunderstand. It is not the leeches that make him pale, but, er, that, that and la bas!

Mr deKrugman: You’re pointing at a bunch of random things.

M Drachet: Not at all, I’m pointing at fetid air! Contagion I tell you. Stop looking at the leeches.

Mr deKrugman. Look, are the leeches to teach a painful lesson or to help the patient get better?

M Drachet: Can they be both?

Mr deKrugman: No.

M Drachet: To be honest monsieur, we do it because we’ve always done it.
But our meticulous research shows that if the patients have, er, died in the past – it wasn’t the leeches fault! It was, um, something else!

Mr deKrugman: I strongly recommend an infusion of fresh blood.

M Drachet: But if we tried something new and it proved better, why our reputation for competence would be in tatters – you laugh sir?

Mr deKrugman: No sir, I weep. I weep.

[They continue to bicker as the bloated leeches suck happily at the patient]

The Sunday Business Post’s Money section has an article on the possibility of not renewing the Eligible Liabilities Guarantee (ELG) when it expires at the end of the year.   (A FAQ on the guarantee is available here.)   The article focuses on arguments made by Wilbur Ross for not renewing the guarantee. 

Ross, who owns 7.7 percent of Ireland’s only privately-controlled bank and sits on its Board, told The Sunday Business Post that the extended liabilities guarantee (ELG) was “severely impeding the recovery of the banks” because of its high cost and should be scrapped.

“There is no reason for [the] government to extend the ELG,” he said.   “Ending [it] will be viewed favourably by the markets as a major step toward the normalisation of Ireland’s financial system and will facilitate the sovereign’s access to international credit markets.”

Ross said that the low interest rate environment, combined with the high cost of the ELG, which will cost Bank of Ireland €400 million this year, was keeping the banking system from returning to profitability.

An aspect worth considering is that, even if the explicit guarantee is not renewed, past experience suggests that the liabilities in question will be implicitly guaranteed at zero cost to an 85 percent privately owned bank.

As linked to by Philip below, Ashoka Mody reignites debate on the default option.   His views must be taken seriously given his vast experience on economic crises.   But it is important to put his proposals in context.   They are largely aimed at European policy makers.   A large private/official-sector debt write off, followed by a commitment to provide necessary funding support as countries moved in a phased way to the low debt/balanced budget model common for states in the US, could well be a route out of the current crisis.

The problem is that this option is not on offer.   In these circumstances, the more a default option is kept on the table as a possible future choice, the harder it will be to regain creditworthiness.   Who would want to buy Irish bonds now if they stand a significant prospect of facing write-downs on their investments in the future?    To the extent that expectations of default remain high, the concern is that it would be less than the orderly/supported model described by Ashoka.   The evidence from past defaults is that they come with large output costs.   The fear of the crisis entering a new virulent phase would undermine confidence and growth in the present, making it harder to stabilise the vicious feedback loops between the banking, fiscal and real sectors. 

An implication is that it is important to move decisively in one direction or the other.   Either get on with the type of solution proposed in the article or take the default option off the table to the maximum extent possible.   With the first option not actually available, the Irish government have moved in the second direction – with reasonably good results in terms of the restoration of creditworthiness.    This option can only work with a strengthened institutional structure for EMU – Patrick Honohan’s euro 2.0.    A core component must be a strengthened lender of last resort for sovereigns backed by fiscal rules that limit risk and moral hazard.   The ECB’s OMT programme – however rationalised by the ECB itself – is an important step in this direction, but more needs to be done.

The Commission has provided a useful contribution to the size of fiscal multiplier debate.    The disagreements between different analyses are not really surprising given the limited number of observations everyone has to work with.   A particularly useful addition is the addition of controls for sovereign default premia.    The literature on sovereign default has emphasized the output costs associated with default (see here), even if the channels of causality are murky.   This is likely to lead to a significant “fear of default” effect on growth, underling the importance of lowering default risk in the broad crisis-resolution effort. 

But in one important respect the Commission lets itself off the hook too easily.   Rightly recognising the importance of lowering sovereign bond yields (and with it the perceived probability of a default on private bond holders), it emphasises the importance of lowering debt to GDP ratios.

When discussing the negative short-term output costs of consolidation it is important not to lose sight of what the counterfactual would be. For the most vulnerable countries, exposure to financial market pressures means there is no alternative than to pursue consolidation measures. The alternative of rising risk premia and higher borrowing costs would be worse for these countries, and consolidations are needed to restore fiscal positions and put debt projections back on a sustainable path.

However, for countries without their own central bank to act as lender of last resort (LOLR) in extremis, and with high debt/deficit levels and weak/uncertain growth prospects, creditworthiness will be fragile for the foreseeable future.   Central to creditworthiness will be design of euro zone LOLR arrangements.   Modest reductions in official debt will not change this underlying fact – though would certainly help.   I think Ireland stands a reasonable chance of avoiding a formal second bailout programme.   But we should not forget that if it does avoid such a programme, it will be significantly because of the available of a quality LOLR backup, possibly through the OMT programme.  

The fiscal adjustment conditions underlying this back up should be: (i) reasonable (i.e. do not push the capacity of a government to deliver fiscal adjustment beyond breaking point; (ii) reliable (i.e. investors should be confident that the support will be there without a forced private-sector default); (iii) flexible (i.e. the conditions should not be designed so that the country is forced to pursue ever larger fiscal adjustments if growth disappoints; and (iv) the link between bank losses and sovereign debt should be broken (taking away a lingering source of uncertainty about the country’s true fiscal position.  

The Commission clearly believes that it is critical for credibility that governments meet the nominal budget deficit to GDP targets set down in their programmes.   But what it is really important is that it is credible that the government will meet its conditions – which could be made growth contingent.  

It has to be recognised that such arrangements do require that the stronger euro zone countries take on substantial risk.   We have to accept that the quid pro quo for this will be stronger collective rules and surveillance.   It is a two-way process. 

For the Irish case, there is a common interest in supporting a “well-performing adjustment programme” to demonstrate that this approach can work.   Part of this could be relieving the burden of official debt, with a restructuring of the PN/ELA arrangements holding the most promise.   But the design of ongoing LOLR arrangements is also critical.   The good thing about a mutual advantage argument is that it does not depend on allocating blame for past “sins”.   There is plenty of blame to go around.   But as Derek Scally argues today, arguments based on blame are unlikely to get us very far.